A letter of credit (“LC”) is a promise by an “Issuer” (e.g., a bank or corporation) to make an unsecured payment (generally a fixed cash value), upon satisfaction of the documentary conditions specified in the letter of credit, to a “Beneficiary” on behalf of an “Applicant.” Letters of credit have a fixed cash value (or “Stated Amount”) so that the Beneficiary has certainty as to the payment it can demand and the Issuer has certainty regarding its potential payment obligation, so it can manage its liquidity accordingly. Bank issuers of letters of credit generally set aside a fraction of the Stated Amount in the form of capital and liquid assets as only a small portion of issued LCs are expected to be drawn by Beneficiaries at any given time. Letters of credit are typically subject to the Uniform Customs and Practice for Documentary Credits (2007 Revision), International Chamber of Commerce Publication No. 600 (the “UCP”) and the law of the jurisdiction indicated in the letter of credit.
A letter of credit is composed of three separate commitments: (i) the underlying contract between the Applicant and Beneficiary, (ii) the contract between the Applicant and the Issuer whereby the Applicant promises to repay the Issuer for any payments made to the Beneficiary in accordance with the terms of the letter of credit, and (iii) the letter of credit itself, whereby the Issuer is obligated to make payment to the Beneficiary for the Stated Amount in accordance with the terms of the letter of credit.
In order to draw upon the letter of credit, a Beneficiary or its advising bank is required to present a demand for payment to the Issuer or its nominated person or confirming bank and provide the necessary documentation. Conventionally, this could be by facsimile, in hand delivery, or by text in a SWIFT message. Accordingly, the Issuer or its confirming bank either will honor such demand (i.e., make payment to the Beneficiary) in accordance with its internal procedures, provided the documentary conditions of the LC have been met, or will dishonor such draw request (i.e., not make payment to the Beneficiary). If payment is made by a confirming bank, the confirming bank will then seek reimbursement from the Issuer. While many letters of credit are drafted to be “payable on sight,” it typically requires at least several business days to receive payment, because of the need to review the documentary requirements and complete internal procedures, which may be an unacceptable delay for certain use cases.
If the Issuer of an LC were to become insolvent at the time of presentment of a demand for payment by the Beneficiary, the Beneficiary may not receive its payment from the Issuer. The Beneficiary thereby has unsecured counterparty risk to the Issuer. Letters of credit are also generally issued by banks or affiliates of the Applicant. This presents default correlation (“wrong way risk”), particularly when the applicant of the letter of credit is also a financial institution. Both unsecured counterparty risk and wrong-way risk are significant impediments to the broader acceptance of letters of credit for new use cases.
In some implementations, an Applicant deposits cash in advance with the bank issuing the letter of credit for the Stated Amount of the letter of credit. This is for the protection of the issuing bank to be repaid, not the Beneficiary. These cash accounts are not segregated and held exclusively for payment of the letter of credit. They are not held for the benefit of the Beneficiary and do not increase speed of payment or guarantee payment. Further, depositing cash into a segregated custody account is particularly expensive as it would provide no return, which is one reason it doesn't occur in practice. Currently, letters of credit are not designed for real time immediate payment, particularly under stressed financial conditions, after considering the operational set up and economic incentives of the banks issuing the letters of credit.
Once a letter of credit is issued, any amendments must be approved by the Issuer, the Applicant, and the Beneficiary in writing. This can be expensive and time consuming to approve and document amongst the parties and, at a minimum, could take several days. For an Applicant that requires daily amending of its letters of credit, the traditional system cannot meet that timing requirement.
Financial Market Infrastructure (“FMI”) is a system for clearing, settlement, or recording payments, securities, derivatives or other financial transactions. FMI that manages credit risk require that participants deposit “prefunded” initial margin or performance bond and prefunded contributions to mutualized default or guarantee funds. Letters of credit are currently not deemed to be “prefunded” by many regulators and are viewed as unsecured counterparty risk. The Basel Committee on Banking Supervision (“BCBS”) and International Organization of Securities Commissions (“IOSCO”) also recommended global standards for margining of non-cleared over-the-counter (“OTC”) derivatives, and such recommendations have been implemented by local regulators around the world. Letters of credit are similarly not deemed to be “prefunded” by many regulators to qualify as eligible assets for initial margin for OTC uncleared derivatives.
Clearing participants and derivatives counterparties experience continuous changes in their current and potential future exposures as a result of changing market prices and portfolio positioning. The calculated amounts due for initial margin, performance bonds, and default fund or guarantee fund contributions can vary significantly throughout a trading day. A traditional letter of credit, assuming it could be an acceptable form of collateral, is inefficient because of its static nature as it's not designed for daily amending and rebalancing. For example, a market participant would not wish to pay for the capacity of $100 Stated Amount of a letter of credit issued to a single Beneficiary if the Applicant's risk is changing frequently and it may soon only be required to post $1 of collateral to that same counterparty, thus making letters of credit an inefficient tool. Rather the Applicant would prefer to be able to reduce the Stated Amount of the letter of credit to $1 and increase the Stated Amounts of other letters of credit where it may be able to use the capacity. Traditional letters of credit cannot reliably amend Stated Amounts amongst Beneficiaries on a daily basis.
The techniques introduced here may be better understood by referring to the following Detailed Description in conjunction with the accompanying drawings, in which like reference numerals indicate identical or functionally similar elements.